Asset Bloat Isn’t What You Get After Eating Too Much Mexican Food

There are probably plenty of four letter words that come to mind when you look over your mutual fund statement for the past few months, but there are also a couple of five letter words you should watch out for:  asset bloat.  No, it’s not what you get after eating too much mexican food, although that sucks too.  Asset bloat is when a mutual fund becomes too big for it’s own good.

When Bigger Isn’t Better

While bigger is definitely better when it comes to boats, airliners, chicken enchiladas, and raises at work, the same can’t be said for mutual funds.  When a mutual fund becomes too large, it may have trouble executing its strategy effectively.  Think about it:  you’re the manager of a popular and successful mutual fund.  You’re the toast of every cocktail party.  Everybody is impressed by how huge your portfolio is and you’re scoring the babes left and right.  Life is good.  One day, after a late night of partying with supermodels, you arrive at the office and are informed your fund has become so popular, investors have just poured another $2 billion into your fund.  “Crap!” you exclaim.  “What am I supposed to do with all this money?”  While you might be tempted to waste it on hookers and blow, that would be wrong.  It’s shareholder money and you’re supposed to act in their best interest. 

Unfortunately, you’ve been out partying every night the past month and haven’t uncovered any bargains in the market.  Or maybe the market is just unreasonably overvalued.  Although some friends out there are allowed to hold large amounts of cash in reserve and wait for a bargain before investing, yours isn’t one of them.  Your investors expect you to be 100% invested in stocks all the time.  So what do you do?  You’re forced to buy more of what you already own whether you think they’re overvalued or not.  You don’t have a choice.

Asset bloat hurts shareholders because it limits what your fund manager can do with your money.  A fund with $40 billion under management is excluded from whole segments of the market merely because they control too much money.  Think small-cap stocks are the next big thing?  Too bad.  You can’t buy any of them because the amount of money you have to employ would immediately drive up the price of any stock with a market cap of less than a few billion dollars.  As a result, fund shareholders end up with what amounts to an index fund but at 5 times the cost.

Asset bloat is especially bad for small-cap funds.  There is simply no way a large fund can buy or sell large positions in small-cap stocks without negatively affecting their prices.  This is why it’s important for fund companies to act quickly to close off funds that are growing assets too quickly for their own good.  In fact, the willingness of a fund company to do this is a good way to tell who’s interests your fund company is looking out for: yours or theirs.  Vanguard and Dodge & Cox are both very good about this;  Fidelity not so much.

 There’s Gotta Be A Better Way!

I knew you saw this coming.  There is indeed a better way.  If you’re going to end up with what amounts to be an expensive index fund anyway, why not just invest in an index fund to begin with and cut out the middle man?